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Practically Understanding Non-GAAP Earnings Adjustments

Over the years, I’ve written a lot about earnings adjustments and non-GAAP earnings.  There are several basic questions to answer:

1) Which matters more?  GAAP earnings or non-GAAP earnings?

In the short-run, non-GAAP earnings matter more for two reasons: a) the non-GAAP earnings attempt in principle to eliminate special factors and estimate the change in run-rate earnings or free cash flow.  If done properly, it is a very valuable exercise.  If done wrong, it’s just an advanced form of chicanery, where companies attempt to keep the stock price higher than it deserves to be, before gravity catches up with them.  Gravity will catch up regardless and eventually, because fooling Ben Graham’s weighing machine invites a rude payback with compound interest.  Ask Enron.

b) the second reason is a weaker one, but the sell-side performs a service by estimating earnings, and they use non-GAAP earnings.  It is a control mechanism that allows investors to measure the progress of companies in the short-run.  Note that this does not encourage short-termism unless the non-GAAP adjustments are done wrong.  It’s fine to talk about the long-run, but what progress are you making toward it?  If the non-GAAP metric does not reflect the best efforts of the management team to create the long term value, then they need to adjust their non-GAAP earnings metric to reflect what maximizes long-run value creation.  After that, educate the sell-side on why you are right, and let the buy-side quietly consider whether they can improve on it.

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That said, GAAP earnings are more important for the long run.  Even more important is the growth in book value plus accrued dividends.  These measures take into account the one-time adjustments.  The many one time adjustments.  THE CONSTANT ONE TIME ADJUSTMENTS!!  

(Ahem.) Management is responsible over the long haul for all of the things that they never anticipated, because they are supposed to be prepared for them on average.  It’s fine to complain about weather affecting sales or margins for one quarter, but to complain about it more than twice in a decade means you aren’t prepared as a management team.  The same applies to writing down goodwill and other asset values.  One surprise every now and then is fine, but if it becomes annual then it should be planned for… perhaps the recoverability estimates aren’t very good at all, and you need to write down ten years of a lack of expected profitability now, rather than eating the elephant of subpar decisions one bite at a time.

2) What should we look for in earnings surprises?

a) Be wary of companies that always beat estimates.  Those that do are one of two things — stupendous, or manipulators.  Earnings should be somewhat ragged, even for a growth company.  I actually like my companies to miss estimates every now and then, because it proves genuineness.

b) Be wary of companies that beat positive estimates frequently, but never seem to have GAAP earnings or book value that grows.  What that means is that the non-GAAP metric may not truly represent what is building value for the firm.

c) Be wary of companies that beat positive estimates frequently, and yet have to raise a lot of capital because the business isn’t throwing off a lot of cash that can be reinvested in the business.  Non-GAAP metrics should be strongly related to free cash flow, which should reduce financing needs.

d) For companies with negative forecast earnings, watch the date closely for when earnings are supposed to go positive.  If you see that date extended more than once, you might want to sell.

e) If a stock trades at a low valuation, don’t make too much out of missing earnings if the book value grows at a decent rate.

3) What else should we know?

a) Earnings misses and beats are frequently overestimated in importance.  Business has irregularities; get used to it, and don’t panic off of one or two bad numbers.

b) But repeated misses probably should be sold, unless the valuation is so cheap that an activist would have an easy time with the stock.

c) If a management is good at managing capital, and honest, an earnings miss can be a great opportunity to buy.  Remember that not all value is driven through short-term earnings.  Clever use of free cash flow to do small acquisitions that can be grown organically can be underestimated.  During times of crisis, a genuinely clever management team can occasionally do amazing things as conditions seem to be falling apart, by buying cheap assets from mis-financed sellers who need quick cash.

d) Stocks with high valuations should use excess cash to pay dividends; those at low valuations should buy back stock.

e) The height of the stock market tends to be determined by long-term estimates of unadjusted future earnings or free cash flow, rather than the current period expected earnings.  As with everything in investing, don’t get too excited about anything.  This is a business, and not primarily a game, though many things are game-like.

f) Situations where M&A are involved are always more complex, and require special handling.  I can’t give a simple general answer there.

g) Actual GAAP earnings and non-GAAP earnings do not live on the same planet on average.  At some point, I will put out a post showing how inflated non-GAAP earnings are on average versus GAAP earnings.  I have the study design ready to go, and just have to run the calculations.  If you look at past earnings, and compare them to forecast earnings, the naive will say, “Wow, what growth!”  The experienced will say, “There are things in the non-GAAP earnings that will not factor into long-term growth in value.”

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That’s all for now.  Your quality thoughts in response are always welcome, though I can’t answer every comment.

Non-GAAP Earnings newconstructs_nwl_nongaapillusions_2016-09-23

Non-GAAP Earnings

 

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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